Inflation And Stock Valuations May Ignite And Support Long-Term Gold Rally

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Includes: DGL, DGLD, DGP, DGZ, DZZ, GEUR, GHE, GHS, GLD, GLDI, GLDW, GLL, GTU, GYEN, IAU, OUNZ, PHYS, QGLDX, SGOL, UBG, UGL, UGLD
by: Zoltan Ban

Summary

Gold has likely seen a price bottom in late 2015. Meanwhile, its main competitors, namely paper assets like stocks and bonds, are looking increasingly unattractive.

The prospect of the next recession being of longer duration, followed by a weak recovery also makes gold attractive for the longer term.

Mining production growth prospects are not very bright either, meaning that gold's scarcity value is intact going forward.

There are many ways to see gold (NYSEARCA:GLD) as an investment. In my personal view, gold's allure depends to a great extent on the desirability of other investment assets. For instance, when expectations are that investing in stocks may yield returns in the double digit range, and bond prices are also doing well, gold is not a very attractive investment.

There are, of course, other independent drivers of gold prices, such as mining, perceived geopolitical and financial risks, expectations on inflation and so on. But in the end, every unit of fiat currency on this planet ends up being attracted to whatever investment is perceived to return the most over a pre-determined time horizon.

In regards to stocks, a quick look at the S&P P/E ratio is enough to help us understand just how unattractive stocks are becoming through the current rally.

Source: multipl.com

As we can see from the chart, stocks are now becoming very expensive. The only two times valuations were higher happened to be as we were entering the two previous stock market sell-offs in response to past recessions in 2000 and in 2008. There are, of course, always opportunities to buy certain stocks, even within such a overbought market. Nevertheless, logic would dictate that some stocks would have to be dumped, while buying into those stocks that still have value within this market. And the selling should be out-pacing the buying at individual portfolio and overall market levels, until the market's P/E ratio is brought back to the perceived long-term reasonable level.

That is not happening, however, at least at market level, thus the P/E keeps rising for now. I am sure however that it is happening at individual portfolio level to some extent. It is just that it is happening at a small enough level that it is not yet affecting the market.

Inflation

The US official inflation rate in the first month of 2017 came in at 2.5%. Not a spectacularly high rate by any means. It is just slightly higher than the official, much-desired target of 2%. It is however the highest rate in almost five years. The increase in the rate of inflation generally tends to be one of the bullish signs for gold, because when there is inflation, gold can play its historical wealth preservation role.

Since 2008, however, we are very far from living in a financial environment where the pre-2008 assumptions still apply. I personally do not think that for the short to medium term gold is a practical and effective hedge against inflation. Inflation does, however, have the potential to knock out the other major paper competitor to gold, aside from stocks — namely bonds.

With inflation rising, the artificially low interest rate environment will come to an end. It is not even about what the central banks around the world will do in response, but simply due to the fact that the low interest that bonds pay is no longer very attractive. The current yield on a US ten year note is under 2.4%, which is less than the rate of inflation recorded in January.

In Europe, inflation also picked up to levels not seen in many years. The difference between the rate of inflation and major bond yields of various Euro zone members is even higher. Italy for instance, which many currently see as the next Euro country which might be next in line for default after Greece, is currently benefiting from ten year yields of just 2.1%, which is close to the inflation levels we are seeing in the Euro zone.

In other words, Italian bond buyers are paying to buy ten year bonds which yield nothing more than current inflation rates in the Euro zone, issued by a country which currently has its fiscal viability under legitimate question.

It is entirely possible that bond traders may see a return to lower inflation rates going forward, even though it seems that expectations for inflation in the US for the next three year is for 2.9% per year. In Europe expectations for inflation this year and next is for 1.7% and 1.4% respectively, which is far less than what we are expecting in the US. It is a huge leap however compared with the inflation situation from the past few years.

Source: European Commission.

While the expected inflation rates in the EU are lower compared with expected US rates, the gap between Euro bond yields and US bond yields will in fact be much higher, especially when we are looking at German bunds which currently yield about nothing.

Under such circumstances new bonds which were issued in the past few years, worth tens of trillions of dollars, which largely yield very little, will become very unattractive holdings. Newly issued bond yields will have to go up, while currently held bonds will be sold at a discount.

Thing is, the money that is likely to exit the bond market will have nowhere to go, because as I already pointed out, stocks are not particularly attractive at this point either. Some money will still go into stocks, but aside from some limited opportunities, it makes very little sense to buy broadly into the stock market.

With paper looking dull, gold shines.

As I wrote before, the main thing that brought the last gold rally to an end was the surge in the stock market. It came as the rally in gold was already at a relatively mature level, and the realization came once it reached $1,900 an ounce in 2011 that there was no prospect of it going any further up. There was simply nothing left to support the rally that time around.

It was increasingly clear that an economic apocalypse was not in the cards, even though the recovery was rather anemic. Inflation was not going to be a problem, despite all the money printing, because there was somewhat of a jobless recovery at the time. There was therefore no reason for momentum investors to continue to park it in gold, especially given the rally in paper assets.

Money tends to follow the assets with most potential return and gold was no longer it. In fact, there was little logical incentive left even for those holding on to gold for the long term as a way to preserving wealth and as insurance against an economic calamity to continue to hold on to it, once the speculators started rushing for the exits, it was no longer such a great vehicle for wealth preservation for the next few years.

The reverse seems to be true now that gold seems to have put in a solid bottom in late 2015. Stocks are largely overvalued, with fewer and fewer opportunities out there in terms of picking up any stocks with potential for decent returns for the longer term. Bonds seem increasingly unattractive with central bank activity and inflation both making the huge volume of bonds issued in the past few years look increasingly undesirable, given the low interest rates attached to them.

We should also consider the fact that we are likely to see a global economic slowdown between now and the end of the decade, which will make the already unattractive stock market a place which everyone will want to exit, once it becomes obvious that the big sell-off is on. The bond market will see a reversal of the current trend of weakening, especially if a global slowdown will cause the current moderate revival of inflation to be wiped out. Having said that, the yields are just not all that attractive.

Gold on the other hand is likely to receive a boost from the outflow of money from stocks, whenever the current bull market will end. With that boost, it will automatically look better than low yielding bonds, which can create on a trend that feeds on itself, with many investors who otherwise would have chosen getting out of stocks and getting into bonds, choosing to allocate a part perhaps into gold instead, in order to get in on the upward momentum.

Next gold boom might last much longer

Another aspect that we need to understand is something that I spent significant time on in the past, writing in regards to what the current interest rate environment means for the next economic downturn. In a nutshell, due to the already very low interest rate environment we are in, the next recession is likely to be far longer, with a far less robust recovery, due to the fact that there will be very little in terms of lower interest rate support coming in, given that interest rates are already so low going into the recession.

Other features that I see as possible during the next economic downturn is a potential spike in commodity prices, which may seem unlikely at first sight, but nevertheless I do believe that we are likely to see, due in part to the timing of the 2014 oil price collapse in relation with I will not go any further into this subject.

I wrote series of articles explaining this important and complex issue. I want to invite anyone who wants to explore it in more detail to take the time and read it (Part 1, Part 2 Part 3, Part 4). I personally think that it was one of the most important macroeconomic works I did last year, which I believe to be essential for longer-term investors, including those looking to hold gold.

A longer recession and a weaker recovery, associated with a possibly inflationary environment due to commodity price spikes would make the next gold rally perhaps less impressive in terms of yearly gains, but of much longer duration.

Gold mining likely to be bullish for prices, due to probable decline in production going forward

According to Statista, gold production has more or less been flat in the 2015-2016 period. Even before then, growth in production started to slow as we moved further and further away from the price spike, which stimulated more mining investment. We are now likely to see the beginning of mining production decline, in my opinion.

The factor I am looking at is China, which despite having only the ninth largest gold reserves in the ground, it is the number one producer by far. With production of 450 tons per year, and reserves of only 2,000 tons per year, it is hard to see as far as I am concerned any scenario where it will be able to maintain current rates of production for much longer, regardless of whether new deposits will be discovered or not. Given that China currently produces about 14% of total global mined gold supply, a sharp decline in production is likely to cause the entire world to enter production decline.

This is important because, from my perspective, mined gold production is more or less the equivalent of central banks adding fiat money supply on to the market. If mined supply growth becomes negative, it increases the scarcity value of gold, lending support to prices. This comes in addition to the gold versus paper assets situation, which as I pointed out, it looks like it is set to fall in the favor of gold.

The timing for these factors coming together and combining with the ultimate factor, namely the market's collective mentality, may not be entirely certain, but as far as I am concerned, the validity of an argument for this being the beginning stages of a new rally in gold is indisputable.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own physical gold & Barrick Gold stock.